216: Avoid This Investment: P2P Lending

How peer-to-peer lending returns are falling for individual investors, yet the lending platforms like Lending Club and Upstart are still growing significantly because they package loans and sell them as asset-backed securities to institutional investors.

Photo by Ferdinand Stohr

In this episode you’ll learn:

How peer-to-peer lending has evolved.

What have returns been for peer-to-peer lending.

How the structure of peer-to-peer lending market has changed

What are asset backed securities.

How does credit enhancement protect asset backed security investors.

How securitizations have meant lower rates for P2P borrowers but made lending on P2P platforms unattractive.

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Episode Summary

Peer-to-peer lending has recently been in the news due to potential protests in China by investors who lost money in the recent collapse of these P2P lending markets. On this episode of Money For the Rest of Us, David explains his own experience with P2P lending investments, the current factors impacting the market, and why there are better options out there for individual investors. For the best insights available on this complex subject, be sure to give this episode your full attention.

The P2P lending environment has changed dramatically over the past few years

David first began investing in P2P lending back in 2006, first with Prosper and later with Lending Club, and Upstart. This method of investing has changed over the years because individual investors no longer loan to the borrower directly. All transactions are regulated by the Security Exchange Commission with investors purchasing payment contingent from the P2P platform. The notes’ return is dependent on the performance of the borrower.

What have been the recent returns for P2P Lending?

Perhaps the biggest discrepancies in P2P lending has been in the advertised vs actual returns. The average return for 2015 vintage loans on Lending Club was 4.41% annualized. For the 2016 vintage, those same annualized net returns were 4.08%. Even though these loans are only 2 years old, across all platforms, the returns are well below expectations and 2% points lower than what returns were for the 2010 to 2013 vintage years.

How are P2P Platforms are growing their platforms despite lower returns
The bulk of P2P platform’s capital to fund loans comes not from individuals but from institutional investors via securitizations. The platforms are able to raise capital through asset-backed securities that have credit enhancements to protect the investors that aren’t available to individuals investing on the platforms.

These credit enhancements protect institutional investors

Investors in consumer loan asset-backed securities are partially shielded from defaults in the underlying loans through subordination, overcollateralization, and reserve balances. Subordination is “a process of prioritizing the order in which loan losses are allocated to the various layers of bonds.” The lowest rated junior bonds serve as a level of credit support for the higher rated bonds. “Overcollateralization means that the value of the underlying loan pool backing the bond is larger than the face value of the bonds. So there might be a $110 or $120 worth of loans backing each $100 worth of bonds.” Finally, there are additional reserves set aside to shield asset-backed security investors from defaulting loans.
.The bottom line – there are better investment options for individual investors

The ability of P2P lenders to raise capital through securitizations has meant interest rates for borrowers have not had to increase as much given the higher levels of borrower defaults. It has also meant lower returns for individual investors. In the current environment, given the illiquidity of P2P notes, individual investors are better served by investing in short-term investment grade bond ETFs.

Episode Chronology

[1:04] There are a lot of issues going on with the global P2P lending market
[5:34] How the P2P lending environment has changed over the past few years
[11:24] Why advertised returns are higher than actual returns
[15:35] How are these P2P lending platforms surviving?
[21:26] How these 3 credit enhancements impact the P2P lending market
[25:51] Individual investors don’t do as well in P2P lending environments – here’s why
[30:00] Here’s the bottom line on why you should avoid P2P lending investments

Transcript

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